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September 15, 2003
Issue 5

 In This Edition - Hedge Funds - Market Highlights

In light of the recent revelations surrounding the illegal trading arrangements between certain Hedge Funds and a handful of Mutual Funds, we thought it would be appropriate for us to devote an issue to the overall topic of Hedge Funds.

What are the definitions and origins of Hedge Funds?

The SEC defines a “Hedge Fund” as a private, unregistered investment pool that employs sophisticated hedging and arbitrage techniques to trade in a variety of financial markets. Unlike Mutual Funds which are also pooled vehicles that invest on a collective basis, Hedge Funds have not been required to register with the SEC on the strength of the argument that they were only open to large sophisticated investors.

The first Hedge Fund was established in 1949 by A.W. Jones who wished to minimize the risk of holding long only equity positions through the short selling of other stocks. He is also credited with introducing leverage and the concept of incentive fees to his pooled investment vehicle. His success was initially not reported until 1966 when Fortune ran an article attesting to the fact that Mr. Jones’ fund had outperformed all other mutual funds available at that time.

Mr. Jones accomplishments ignited a mini boom in Hedge Funds in the late 1960’s, which gave birth to such modern day successes as George Soros, Michael Steinhardt and Julian Robertson.

The Arguments for using Hedge Funds

Hedge Fund managers have long argued that their asset class provides important complementary correlations with more traditional investments in stocks and bonds. A recent example would be those funds which were shorting technology stocks during the sell-off of 2000-2002. There also exist now many different flavors of Hedge Funds, allowing investors to gain exposure to markets which might otherwise be difficult for them to practically access. Examples of these funds would include those which attempt to arbitrage the inefficiencies in convertible bonds or which may invest in the sovereign debt of foreign issuers. “Managed Futures” is the current strategy we hear most often discussed. Hedge Funds also focus on what has come to be known as “Absolute Return”. Absolute Return is the promise of providing real positive returns rather than trying to outperform any given benchmark, such as the S&P. This mantra has become intoxicating to some in light of the negative performance of the broad equity indices over these past few years. Finally, many of these funds have been able to attract many of the best mathematical and academic minds that Wall Street had to offer.

The Arguments against using Hedge Funds

While there are many good reasons to add a Hedge Fund to one’s overall allocation, these funds come with a host of less than desirable features. The fees associated with these funds tend to be higher than traditional management fees and they frequently incorporate what old A.W. Jones insisted on having – a cut of the profits on top of the management fee. In addition, there is almost always a required period of illiquidity of one to six months, and there is no transparency as to what these funds hold at any one time. The absence of registration requirements and therefore basic information on the managers such as their ADV form is of concern. It may be possible for a fund manager to implode a fund in one state and then rise from the ashes in another without the new investors having any information on his past failures. There have also been some recent era spectacular busts, examples of which include Granite Capital in1994 and Long Term Capital Management in the fall of 1998. LTCM’s principals were considered to be the “quill” of the entire industry and yet their $100 billion failure forced the coordinated intervention of the Federal Reserve and over a dozen of Wall Street’s largest firms to avoid a cataclysmic unwind. For those interested in reading more, we would highly recommend, “When Genius Failed, The Rise and fall of Long Term Capital”, by Roger Lowenstein.

Recent News and Events

The SEC is currently reviewing its registration policy regarding Hedge Funds, and is considering requiring that all funds register as investment advisors. This is due in part to the desire of the industry to sell these products to those who are less sophisticated and in part to the behavior of the funds themselves. The recent investigations into “late trading” of mutual funds will no doubt add fuel to the fire of registration.

 Market Highlights

  9/12/03 8/29/03 6/30/03 3/31/03 12/31/02
DJIA US 9471.05 9415.82 8985.44 7992.13 8341.63
S&P 500 US 1018.63 1008.01 974.5 848.18 879.82
Nasdaq US 1855.03 1810.45 1622.80 1341.17 1335.51
EAFE Int'l Equity 1107.38 1072.14 1025.74 868.55 952.65
5 Yr Treasury 3.150 3.494 2.41 2.71 2.74
5 Yr AAA Muni 2.540 2.820 2.17 2.50 2.59
10 Yr Treasury 4.229 4.427 3.52 3.80 3.82
10 Yr AAA Muni 3.860 4.080 3.30 3.75 3.72
30 Yr Treasury 5.135 5.190 4.56 4.82 4.77
30 Yr AAA Muni 4.740 4.890 4.50 4.66 4.69
EUR Currency 1.1154 1.0908 1.1425 1.0899 1.0488
JPY Currency 117.06 116.65 120.06 118.67 118.69
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